Latham & Watkins Finance & Real Estate Department

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1 Number 309 July 11, 2003 Client Alert Latham & Watkins Finance & Real Estate Department FERC s investigation into Enronaffiliated qualifying facilities and its broader review of its QF files may expose QF owners to substantial liabilities... FERC Investigation of Qualifying Facilities Following up on an investigation begun in the fall of 2002 into several cogeneration facilities owned in part by Enron Corporation (Enron), 1 the Federal Energy Regulatory Commission (FERC or the Commission) issued two additional orders on February 24, 2003 and May 2, 2003, expanding its investigation to five additional facilities in which Enron has or had an ownership interest. 2 Like FERC s previous orders into Enron-owned plants, the two most recent orders set for hearing the issue of whether the five identified qualifying facilities (QFs) have violated the ownership criteria for QF status as set out by the Public Utility Regulatory Policies Act (PURPA) and its implementing regulations. In addition, FERC has required Enron to submit a list of all QFs in which it had an ownership interest after its acquisition of Portland General Electric Company and has indicated that it will be closely checking each for compliance with QF requirements. Perhaps the most important effect of FERC s closer look at Enron s QF activities is its decision to review its QF files for similar potential violations, and its apparent intent to more closely scrutinize all existing and future notices of QF self-certification. As FERC stated in both its February and May 2003 orders, it is reviewing its QF files to determine whether other facilities, claiming QF status, do not meet the criteria for QF status. 3 As part of that examination, FERC s Office of Markets, Tariffs and Rates has now issued letter orders to 10 QFs, seeking sworn affidavits from a company officer confirming the accuracy of the information contained in prior notices of self-certification, as well as additional documentation regarding the QF s current ownership structure. 4 All owners or potential owners of facilities claiming QF status through self-certification should be alert to the outcomes of the Enron proceedings, as well as to the Commission s stated intent to review its other QF files. Requirements for QF Status The term qualifying facility or QF was first defined in the Public Utility Regulatory Policies Act of 1978 (PURPA), 5 which set out the basic requirements for QF status and granted QFs certain rights and benefits. PURPA s statutory scheme was designed to encourage the use of non-utility energy resources and to reduce the country s reliance on traditional fossil fuels and foreign oil. Accordingly, PURPA defines a QF as a small power production or cogeneration facility that complies with certain defined ownership restrictions and meets certain defined operating and efficiency standards. With respect to the ownership requirements, which are the focus of the Enron investigations, PURPA requires Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2003 Latham & Watkins. All Rights Reserved.

2 that the facility may not be owned by a person primarily engaged in the generation or sale of electric power (other than from other qualifying facilities). FERC s implementing regulations provide more explicit guidance on the ownership restrictions, stating that a facility will be considered ineligible for QF status if more than 50 percent of the equity interest in the facility is owned by an electric utility or utilities, an electric utility holding company or any combination thereof. Additionally, [i]f a wholly or partially owned subsidiary of an electric utility or electric utility holding company has an ownership interest [in] a facility, the subsidiary s ownership interest shall be considered as ownership by an electric utility or electric utility holding company. 6 Benefits of QF Status As noted above, QFs have been granted several important rights and benefits under PURPA and its implementing regulations, including the following: A QF is exempt from state laws and regulations respecting its rates and its financial and organizational structure. 7 Most QFs are exempt from the majority of the provisions of the Federal Power Act (the FPA). 8 For example, a QF is not required to file any rate schedule or service agreement with FERC pursuant to Section 205 of the FPA. In addition, no FERC authorization is required under Section 203 of the FPA for the owner of a QF to sell or otherwise transfer its interests in the QF. A QF is not considered to be an electric utility company as defined in the Public Utility Holding Company Act (PUHCA) and is therefore exempt from regulation under PUHCA. 9 A QF can require its host electric utility to purchase the QF s energy and capacity at the utility s avoided cost. 10 For certain QFs, the long-run avoided cost used to establish the purchase price in their power purchase agreements is higher than the current average market price for sales from facilities in the applicable market. Self-Certification of QF Status Under Commission regulations, a cogeneration or small power production facility that meets the applicable ownership and operating/efficiency criteria is automatically a QF. 11 QFs can either apply for affirmative Commission certification of QF status or can selfcertify their QF status with the FERC. In order to self-certify (or self-recertify), the owner, operator or representative of the facility must file a notice of selfcertification with the Commission, with each electric utility with which it expects to interconnect, transmit or sell energy, and with the appropriate state regulatory authorities. 12 Until the recent spate of Enron-related investigations, it was not FERC s practice to investigate QFs that used the self-certification or self-recertification process, relying instead on purchasing utilities and any other affected entity to bring potential compliance problems to FERC s attention. FERC s Recent Investigations Into QF Compliance When FERC began its investigation into certain Enron-affiliated QFs in late 2002, it initially focused its attention on Enron s use of special purpose entities to improperly retain control over QFs in which it had an interest. Thus, the Commission s 2002 orders all involved QFs for which the non-utility ownership share was held by partnerships specifically created by Enron to take over Enron s interest (the RADR partnerships). While the Commission was aware when it 2 Number 309 July 11, 2003

3 recertified these facilities that Enron had provided loans to the RADR partnerships a relationship that FERC has previously found acceptable if the loan is made at market rates subsequent investigations by the SEC revealed that Enron and its officers may have improperly retained significant control over the QF as well as undisclosed rights to the proceeds from the project. In the orders issued in the spring of 2003, however, FERC has begun investigating Enron-affiliated QFs that did not involve the partnerships investigated by the SEC. Thus, in the February 24, Order, FERC extended its inquiry beyond the RADR partnerships and is examining other situations where Enron provided loans to help fund the acquisition of a QF interest. While FERC s inquiry again appears to have been triggered by specific evidence that Enron retained improper control over and/or a right to the proceeds from the QF, FERC can be expected to closely scrutinize any situation in which a nonutility owner of a QF is sponsored or funded by a utility. Indeed, FERC has expressed the more general concern in both the February 24 and May 2 Orders that entities claiming QF status may have used self-certification procedures to avoid a thorough examination of whether a facility satisfies the criteria for QF status. 13 The May 2 Order reveals an even broader field of FERC inquiry and concern. In that order, FERC does not appear to be focused on the lack of independence of a non-utility owner of the project but focuses instead on facial deficiencies in the notices of selfcertification and the ownership structures described therein. Specifically, the Commission has questioned the QF status of several Enron-affiliated QFs after its review of the notices of self-certification revealed that Enron affiliates may have had greater than a 50 percent ownership interest and/or control of the facilities at some point in the QF s history. FERC found that the notices of selfrecertification did not explicitly explain the basis on which the claims that the facilities meet the ownership criteria for QF status 14 but did not set out in any detail the specific aspects of the ownership structure that it considered potentially deficient. The underlying Enron self-certifications suggest several possible bases for FERC s concern. First, they do not clearly explain the nature of the various membership classes in which Enron affiliates had an interest, making it difficult to ascertain precisely the various owners relative voting shares and rights to proceeds from the QF. 15 Second, the notices do not explicitly state that the utility-affiliated owners will not and cannot receive more than 50 percent of the stream of benefits from the QF (including a provision in the project documents that prevents the utility owner from increasing its share of the proceeds from the QF). Impact on Non-Complying Facilities The potential costs of an adverse finding with respect to QF status can be quite high. First, any entity that fails to comply with PURPA s QF requirements would not be entitled to an exemption from Section 205 of the FPA absent a waiver and therefore may not be permitted to recover its contractual avoided cost-based rate during the period of non-compliance. 16 Depending on how the relevant power purchase agreements are drafted, a facility that is non-compliant for a given period of time may have to refund the difference between its contractual avoided costbased price and the actual incremental costs of the utility served during the time of non-compliance. 17 Second, in addition to the potential refund liability for any period of noncompliance, some QF contracts may require the maintenance of QF status, and the failure to do so may constitute a default under the contract terms that 3 Number 309 July 11, 2003

4 could trigger contract termination or permanent price reductions. Further, as noted in both the February 24 and May 2 Orders, the Commission has left open the possibility of a greater revocation of QF benefits as a result of noncompliance, including exemption from other sections of the FPA, PUHCA or state laws and regulations, and, in more serious cases, permanent revocation of all QF benefits. 18 Third, failing to meet QF status could threaten the facility s upstream owners ability to claim an exemption from regulation under PUHCA and could subject owners to extensive financial, organizational and reporting regulation by the Securities and Exchange Commission. Moreover, the loss of exempt status may render existing contracts invalid, as any contract entered into in violation of PUHCA s provisions is voidable. 19 Conclusion FERC s broad, backward-looking examination of QF compliance may have far-reaching implications. Even assuming that FERC is primarily interested in potential violations by Enron, its investigation would still cover every QF in which Enron ever had an interest subsequent to its acquisition of Portland General Electric Company. Moreover, there is every indication that FERC could examine any application or notice of self-certification in its QF files and is taking a close look at: 1) situations in which loans or other support are provided by a utility to a non-utility QF participant and 2) any facial deficiencies in a notice of QF self-certification, including any failure to clearly explain the basis for QF compliance. FERC s investigation into Enronaffiliated qualifying facilities and its broader review of its QF files may expose QF owners to substantial liabilities due to non-compliance periods in a given facility s history. In addition, any new application or notice of selfcertification should be made with FERC s heightened concerns in mind. Entities currently owning interests in QFs or considering purchasing QFs should consider consulting counsel to determine the scope of potential past liabilities and to plan for future compliance. 4 Number 309 July 11, 2003

5 Endnotes 1 Order Initiating Investigation and Hearing, 101 FERC 61,076 (October 24, 2002) (investigating Zond Windsystems Holding Company, Victory Garden Phase IV Partnership, and Sky River Partnership) ( October 24, 2002 Order ); see also, Southern California Edison Co. v. Enron Generating Facilities, 101 FERC 61,313 (Dec. 19, 2002) (instituting hearing procedures to investigate the QF status of Cabazon Power Partners, LLC, Zond Wind System Partners, Ltd. Series 85-A, Zond Wind System Partners, Ltd. Series 85-B, and consolidating proceedings with the investigation into the Enron-affiliated QFs identified in the October 24, 2002 Order). 2 The five cogeneration facilities identified in the two orders are: Saguaro Power Company, Las Vegas Cogeneration Limited Partnership, Cogen Technologies Linden Venture, L.P., Camden Cogen L.P. and Cogen Technologies NJ Venture. See Investigation of Certain Enron-Affiliated QFs, et al., 102 FERC 61,199 (2003) ( February 24 Order ); Investigation of Certain Enron-Affiliated QFs, et al., 103 FERC 61,122 (2003) ( May 2 Order ). 3 February 24 Order at 1; May 2 Order at 1. 4 See, e.g., Letter Order from Steve Rodgers to Leonard M. Saari, Docket No. QF (June 19, 2003) (requesting additional documentation regarding QF compliance within 30 days of issuance of order). 5 Pub. L. No , 92 Stat (1978) (codified at 16 U.S.C et seq., inter alia) C.F.R (b) C.F.R (b) U.S.C. 824a-3(a)-(b); and 18 C.F.R C.F.R (a)(1)(i) C.F.R (a)(1)(ii). 13 February 24 Order at 11; May 2 Order at May 2 Order at See Notice of Self-Recertification of Qualifying Facility Status for Cogeneration Facility of Cogen Technologies Linden, L.P., Docket No. QF (Feb. 4, 1999); Notice of Self-Recertification of Qualifying Facility Status for Cogeneration Facility of Camden Cogen L.P., Docket No. QF (Feb. 4, 1999); Notice of Self-Recertification of Qualifying Facility Status for Cogeneration Facility of Cogen Technologies NJ Venture, Docket No. QF (Feb. 4, 1999). The Commission also stated that the selfrecertifications for these facilities filed on January 14, 2000 may have been in violation of the regulations. May 2 Order at See LG&E-Westmoreland Southampton, 76 FERC 61,116 (1996); New Charleston Power I, L.P., 76 FERC 61,282 (1998) ( New Charleston ). 17 See, e.g., New Charleston Power I, L.P., 76 FERC 61,282 (1996); Megan-Racine Assocs., Inc., 76 FERC 61,354 (1996); Pacific Gas & Electric Co. v. Red Top Cogeneration, L.P., 84 FERC 61,138 (1998). 18 See February 24 Order at 22; May 2 Order at U.S.C. 79z(b) C.F.R (c) C.F.R (c). The FPA exemptions do not apply to certain small power producers. Id. at (a) and (b). 5 Number 309 July 11, 2003

6 Office locations: Boston Brussels Chicago Frankfurt Hamburg Hong Kong London Los Angeles Milan Moscow New Jersey New York Northern Virginia Orange County Paris San Diego San Francisco Silicon Valley Singapore Tokyo Washington, D.C. Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you have any questions about this Client Alert, please contact David L. Schwartz, Michael J. Gergen, Julie B. Greenisen, Jared W. Johnson, George D. Cannon, Jr., David G. Tewksbury, Stephanie S. Lim or Natasha Gianvecchio in our Washington, D.C. office or any of the following attorneys. Boston David A. Gordon Brussels John P. Lynch +32 (0) Chicago David K. Rathgeber Frankfurt Joerg P. Soehring Milan David Miles Moscow Anya Goldin New Jersey James E. Tyrrell, Jr New York David A. Gordon San Francisco John H. Kenney Silicon Valley Peter F. Kerman Singapore Mark A. Nelson Tokyo David L. Shapiro Hamburg Jürgen Hübner Hong Kong Mitchell D. Stocks London James Chesterman Los Angeles David B. Rogers Orange County David C. Meckler Paris Etienne Gentil +33 (0) San Diego Joel H. Mack Washington, D.C. George D. Cannon, Jr. Michael J. Gergen Natasha Gianvecchio Julie B. Greenisen Jared W. Johnson Stephanie S. Lim David L. Schwartz David G. Tewksbury Number 309 July 11, 2003